The Best Case for ESG Under ERISA Is Long-Term

Michael Hunstad is head of quantitative strategies at Northern Trust Asset Management (NTAM). The role is a broad one, but a big focus recently for Hunstad has been the evolving topic of environmental, social and governance (ESG) investing in the realm of U.S. institutional investing.

According to Hunstad, outside of the U.S., almost all the institutional business NTAM engages in already involves the ESG lens to some capacity. He says institutions in Europe, Asia and Latin America have come to accept that ESG is a material issue when it comes to long-term asset performance—both as a source of risk and a potential source of return.

“Is ESG a factor, say, in the way of stock value or momentum?” Hunstad asks. “There are two ways to look at this question. The first is to say that ESG is an independent source of risk that must be addressed. In my opinion, you simply cannot argue against this. Consider what happened with Volkswagen’s stock when the emissions cheating scandal came out. That is bad governanc,e and it is absolutely a source of material risk today that will impact your portfolio, if ignored. So if you can measure governance, and you can control the risk around governance, that’s enough for me to say that ESG is a factor that should be addressed during portfolio construction.”

The risk issue may be settled, Hunstad says, but it is equally important to ask the next question, i.e., whether ESG is a positively compensated factor? In other words, will an investor see excess returns for going overweight in ESG-conscious stocks?

“We have to be careful in this analysis,” Hunstad suggests. “I like to say that the best case for higher performance of ESG stocks is over the long-term.”

The case goes as follows. For those companies that have taken concrete steps to comply with environmental regulations or have strong cultures of governance and are globally and sustainably minded, these companies have already borne the cost of embracing this way of doing business. Crucially, the fact already shines through in their financial statements. On the other hand, those companies that have done nothing to consider ESG issues, their financials do not reflect these unknown future costs.

“The important point is to say that these companies will eventually have to bear these costs in the future, which will inevitably be a headwind for their stock price and financial performance,” Hunstad says. “More importantly, we have found that ESG absolutely can be a compensated factor when you weed out low-quality companies from your portfolio. There are stocks out there that rank highly on the ESG perspective that you don’t want to own from a financial perspective. If you get rid of those, the stocks that are left over, the high-qualit,y high-ESG-rated stocks, tend to do very well.”

NTAM rolled out a number of strategies that take this approach nearly five years ago, and Hunstad says the performance has been strong.

“All of them are blowing away the cap-weighted benchmarks,” Hunstad says. “We offer these through our wealth and institutional channels, and the growth has been very rapid.”

One example is the Quality ESG World Strategy, which has outperformed the MSCI World Index by 1.21 percentage points since inception in 2015. Notably, the portfolio holds just 291 stocks out of the benchmark index’s 1,635 holdings. The market capitalization of the Quality ESG World Strategy, however, is still about 80% of that of the MSCI World Index. A fact sheet provided by NTAM summarizes the strategy as follows: “Our process uses a proprietary quality screen that focuses on fundamental characteristics that differentiate a company’s level of quality. Portfolios are then constructed to take active exposures on securities based on their ESG rating and relative quality rankings.”

According to Hunstad, it may take some time for the retirement industry in the U.S. to fully embrace ESG as a positive-performance factor. However, he says, it’s already a best practice to think about ESG from a risk-management perspective. Many are arguing that ERISA, the Employee Retirement Income Security Act, already demands as much. 

“Thinking about ESG risk and about investments can be holistic,” Hunstad says. “You don’t have to silo yourself into an ESG lineup to take advantage of this way of thinking.”

Evolving industry consensus on ESG

Another expert to speak recently with PLANADVISER on the ESG topic is Timothy Calkins, director of fixed income at Nottingham Advisors. He agrees that institutional client expectations are, indeed, evolving rapidly around the question of how environmental, social and governance-focused investment approaches fit into the world of institutional asset management.

Even five or 10 years ago, Calkins says, the consensus was still that investors had to give up some performance by “doing good” in the markets. But more recently, especially since some big meta-studies published in 2015, the conclusion around ESG integration has moved to being either neutral or more often positive from the performance perspective.

In practical terms, Calkins’ firm is already using separately managed accounts (SMAs) as a way to deliver ESG strategies to clients. Some clients choose to really engage with risk management and return-boosting opportunities having to do with the environment, he explains, while others may choose to utilize a gender lens when reviewing the fund managers they use or the companies they invest in. As opposed to mutual funds or collective trusts, the SMAs can be customized to allow clients to uniquely implement their ESG perspective.

“Being able to offer customized ESG solutions is a big part of our future, we feel, as is finding new ways to clearly demonstrate the performance benefits of these strategies,” Calkins says. “Especially when it comes to serving clients under the Employee Retirement Income Security Act, we know the performance conversation is always going to be critical.” 

According to recent research from Morningstar, most investors, across ages and genders, have clear preferences for environmental, social and governance investment products.

This matches the experience of attorneys working with Stradley Ronon. The firm says its attorneys are already helping both registered and private-fund clients incorporate various ESG strategies. They are also advising fiduciaries on the implications of using ESG under ERISA, “such as how integration, shareholder engagement and divestment can be conducted in a manner consistent with ERISA.”

“We simply don’t see ESG going away anytime soon,” says George Michael Gerstein, co-chair of the fiduciary governance practice at Stradley Ronon. “Environmental, social and/or governance issues are a fact of life. Cybersecurity and climate change are two examples.”

According to the attorneys, one factor slowing growth in this domain is widespread confusion over what ESG actually means. In particular, clients want to know how “ESG investing” differs from “impact investing,” “socially responsible investing,” “economically targeted investing,” and “sustainable investing.” They also spend a lot of time explaining that the days are gone when ESG investing consisted primarily of either screening out or divesting from certain issuers/sectors because they do not meet some moral or other noneconomic test.

“Today’s ESG is much more driven by data linking one or more ESG factors and investment performance—an ESG factor can now be a material risk,” the attorneys wrote. “On an even more fundamental level, there is not unanimity on what constitutes an E, S or G factor. ESG is an umbrella term capturing as many as 40 different topics.”